Detroit once exported cars; now, one student wonders if its current legacy will adversely affect other cities.

Stanford University student Brandon Camhi takes a detailed look at the proposed solution to Detroit’s troubled finances and expresses some concerns about its impact on the bond market.

Here we go again. Another epochal battle between Wall Street and Main Street. Since July 2013 when it declared Chapter 9 (municipal) bankruptcy, Detroit has been struggling to restructure its financial obligations. The city’s government, under the auspices of emergency manager Kevyn Orr, recently issued a plan that will allow it to escape bankruptcy and finance future operations. Many different parties, such as creditors, pensioners, and bondholders, have claims to the city’s remaining assets and this “plan of adjustment” allocates remaining resources among these parties.

This plan will be submitted to bankruptcy judge Steven Rhodes for approval. The proposal’s details have already ignited contentious debate: bondholders will receive up to 20 cents per dollar while pensioners will receive up to 50%. At first glance, this allocation may seem just: city workers deserve to earn as much as their deferred compensation as possible, even if it is at the expense of Wall Street bondholders. However, this proposal is far more unsettling than it first appears. By returning meager assets to bondholders, especially when compared to other claimants on debt, Detroit risks unleashing negative effects that will reverberate far beyond its borders.

…Although bond repayment structures are often renegotiated, asking a court to force bondholders to lose value will have serious value. Since only 1 in 10,000 cities with a AAA credit rating go bankrupt three years after a bond issue, Detroit dwells in largely uncharted legal territory. The city’s treatment of bondholders, and the judiciary’s response to it, will be closely watched for what happens to bondholders in Detroit will undoubtedly establish a precedent.

If bondholders appear to be unfairly targeted, the markets will respond. And their response probably will not be pretty. Cities will be forced to offer higher interest rates to compensate investors for perceived increased risk from municipal bonds. Although the likelihood of municipal default will remain extremely slim, especially as the economy begins to improve, risk averse investors will not forget how they were treated in Detroit.

…Appeasing pensioners by gutting municipal bonds may be good politics, but it is undoubtedly poor policy. If municipal bondholders are perceived to be treated unfairly, then market forces will make it more difficult for cities to finance critical infrastructure projects. Perhaps the headlines are misguided. Maybe, in reality, there should be no battle waged between Wall Street and Main Street at all on this issue. Who knows, they might even be on the same side.